In his book, The Little Book That Beats the Market, Joel Greenblatt explains how investors may outperform market averages by following his “Magic Formula” – simple process of investing in good companies (ones which return high returns on capital) at bargain prices (priced to give high earnings yield).
When tested against Standard & Poors Compustat “Point in Time” database on a portfolio of approx. 30 stocks, Greenblatt’s formula actually beats the S&P 500 in 96 % of all cases, achieving an average annual return of 30.8 % over the last 17 years, turning $11,000 into over $1,000,000 over 17 years. Pretty impressive!
Greenblatt’s “magic formula” is a purely quantitative, long-term stock investing strategy that works particularly well for small cap stocks (<1> 1 billion). Essentially, no matter what stocks we invest in, we want a strategy that ensures we can earn much more than we could get from purchasing say a “risk-free” 10 year U.S. government bond generating approx. 6%. Greenblatt’s “magic formula” method of stock investing is one strategy that achieves this.
Value Investing
The central premise in Greenblatts’s stock investing strategy is that of ‘value investing’. Fundamentally, value investing involves buying stocks that are undervalued, fallen out-of -favor in the Market due to investor irrationality. Greenblatt’s formula for value investing you could say is an updated version of Benjamin Graham’s ‘value investing’ approach.
